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Foolish Fundamentals: Stock Dilution

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Stock dilution refers to when a company issues additional stock, for any purpose. Some of those purposes are bad for outside shareholders, some are neutral, and believe it or not, some are actually good. We examine all three scenarios to see how they can affect us as investors.

Let's start with a make-believe company that we can use as a guinea pig to show how its actions can affect its shareholders' ownership. Imagine that this company is a high-tech start-up that aims to one-up stun-gun manufacturer TASER (Nasdaq: TASR) . It's got a new weapon to sell that can be set not just to "stun" but also to "disintegrate," a feature that leaves nothing of its target behind but a hollow afterglow. The company is called Phaser (Ticker: RAYGUN). In 2005, Phaser had 100,000 shares of common stock outstanding, a market cap of $1 million, and $100 of net profits.

Now, we need one more guinea pig. Let's call this one Joe Fool. He's an individual investor, and on Dec. 31, 2006, he bought 10,000 shares of Phaser stock. When the company reported its earnings, Joe was elated to learn that, by virtue of his stake, he vicariously earned $10 worth of Phaser's profits. Little did he know what 2007 held in store for him.

Bad stock dilution In 2007, Phaser decides to engage in the worst of the three main ways that companies dilute their shares: It issues 100,000 stock options to its CEO. For the time being, Phaser has a "basic share count" of 100,000 shares actually outstanding. But because its CEO will eventually exercise his or her stock options (i.e., tell the company to issue 100,000 shares to him or her and then sell them on the open market), Phaser now has a hypothetical, or "diluted," share count of 200,000.

That's bad news for Joe. While he will still own his 10,000 shares, his ownership stake will be diluted once the company issues that extra stock. What does that mean? Well, when Phaser's share count stood at 100,000, and it earned $100, Joe was entitled to 10% (10,000/100,000) worth of those profits, or $10.

But when Phaser issues those 100,000 extra shares, Joe's shares will not equal 10% but just 5% (10,000/200,000) of all shares outstanding. If Phaser earns $100 again the next year, Joe's take from that haul is just $5. Poor Joe.

The CEO, on the other hand, gets 100,000/200,000 worth of the profits, or $50. Lucky CEO!

Thus, the primary reason Fools dislike stock dilution is that it often represents a transfer of wealth from outside shareholders -- you and me -- to insiders.

Ambiguous stock dilution Stock dilution, however, isn't always bad. But before we look at when it can be good, let's consider the iffy situation of a company that acquires another one and pays for the purchase in stock. Say Phaser wants to expand its business, but it hasn't gotten its gun to work just yet. That poses a problem. Phaser's solution is to buy out a rival -- defense contractor General Dynamics (NYSE: GD). Since Phaser hasn't sold anything and doesn't have any actual, er, cash, it wants to issue its own stock to General Dynamics shareholders in exchange for their shares.

Now, General Dynamics has a market cap of roughly $32 billion. With Phaser shares trading for $10 a stub, our intrepid company will have to issue 3.2 billion new shares to acquire its heart's desire. Doing that will dilute Joe and Phaser's other shareholders thousands of times over. In what universe could that much dilution possibly be a good deal for Phaser shareholders?

The answer requires another question: Is Phaser overpaying for its purchase? If Phaser pays a price equal to General Dynamics' intrinsic value as a business, then the dilution created by the purchase does not really hurt Joe. Yes, Joe's slice of the merged Phaser/General Dynamics pie looks much smaller than his slice of Phaser alone does. But the new pie is much bigger. Picture this: Joe is receiving a much thinner but also much longer slice of the Phaser/General Dynamics pie, in return for his original wide but stubby slice of Phaser.

A smaller piece of a bigger pie And there's another possibility to consider. Alone, Phaser may not be objectively "worth" the $1 million market cap that the market accords it. If Phaser's stock is overvalued, then paying for an acquisition in inflated-value stock may be a smarter move than paying in cash. During the go-go '90s, most every acquisition you saw from companies such as Cisco (Nasdaq: CSCO) or Microsoft (Nasdaq: MSFT) was paid for in richly valued stock.

Take my shares ... please!And that brings us to the third major form of stock dilution: secondary offerings. When Phaser gives 100,000 shares to its CEO for a nominal "exercise" price, that's bad for outside shareholders. But what if, before Phaser decides to go that route, the message-board rumor mill gets going and anoints Phaser as the next moon-rocket stock? As Phaser's stock price doubles, triples, and then jumps 10 times more, company management reconsiders, decides not to issue options, and instead sells the 100,000 shares on the open market -- at $600 a pop.

If the company's intrinsic value hasn't changed, and if only its stock price has increased, then this is great news for Joe. After the secondary offering is completed, he again owns 10,000 shares out of 200,000, or 5% -- down from his original 10%. However, Phaser itself is now worth more -- not just from the rumor-bubble pricing of its stock but also intrinsically, because the company has traded 100,000 shares for $60 million in cash. That cash now sits in the company's bank account, and Joe owns 5% of it, or $3 million.

So to sum up, whenever a company issues shares at a price higher than the shares' intrinsic value -- whether it does so to buy another company or to sell the shares and raise cash on the market -- an outside shareholder benefits, despite his or her percentage of ownership being diluted.

And there you have it: the three primary sources of stock dilution, and what they mean to you as an outside shareholder.

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